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11.5 Onerous contracts
Publication date: 30 Nov 2023
us Revenue guide
Onerous contracts are those where the costs to fulfill a contract exceed the consideration expected to be received under the contract. The revenue standard does not provide guidance on the accounting for onerous contracts or onerous performance obligations. US GAAP contains other applicable guidance on the accounting for onerous contracts, and those requirements should be used to identify and measure onerous contracts.
11.5.1 Onerous contract guidance
Reporting entities generally should not recognize a liability for anticipated losses on contracts prior to those losses being incurred unless required by specific guidance. The most common types of contracts for which specific guidance requires recording anticipated losses are construction-type and production-type contracts (refer to RR 11.5.2).
Other guidance that might permit or require the accrual of losses on uncompleted contracts include:
- Separately priced extended warranty and product maintenance contracts subject to ASC 605-20-25-6, which requires a reporting entity to record an anticipated loss if the sum of expected costs to provide services under the contract exceed the related unearned revenue
- Firm purchase commitments for inventory subject to ASC 330-10, which may require a reporting entity to recognize a loss based on an anticipated impairment of the inventory upon acquisition
- Continuing care retirement community contracts subject to ASC 954-440, which requires a health care entity to recognize a loss for expected costs related to providing services and the use of facilities to individuals in excess of expected revenues
- Prepaid health care service contracts subject to ASC 954-450, which requires a health care entity to record a loss when it is probable that expected future health care costs and maintenance costs under a group of existing contracts will exceed anticipated future premiums and stop-loss insurance recoveries on those contracts
- Certain long-term power sales contracts subject to ASC 980-350, which requires recognizing an immediate loss for loss contracts that are not accounted for as a derivative
11.5.2 Construction-type and production-type contracts
Reporting entities should apply ASC 605-35, Revenue Recognition—Provision for Losses on Construction-Type and Production-Type Contracts, to identify and measure provisions for losses on contracts subject to its scope. A reporting entity should not apply the guidance in ASC 605-35 to contracts other than those explicitly within its scope (refer to RR 11.5.3). That is, they should not apply the guidance to other contract types by analogy.
11.5.3 Contracts in the scope of ASC 605-35
ASC 605-35 provides a definition of contracts that are within scope of the guidance.
The guidance in this Subtopic applies to:
- The performance of contracts for which specifications are provided by the customer for the construction of facilities or the production of goods or the provision of related services. However, it applies to separate contracts to provide services essential to the construction or production of tangible property, such as design, engineering, procurement, and construction management. Contracts covered by this Subtopic are binding agreements between buyers and sellers in which the seller agrees, for compensation, to perform a service to the buyer's specifications. Specifications imposed on the buyer by a third party (for example, a government or regulatory agency or a financial institution) or by conditions in the marketplace are deemed to be buyer's specifications.
ASC 605-35 provides a list of example contracts that are within its scope.
- Construction contracts, such as general building, heavy earth moving, roads, bridges, building mechanicals (HVAC)
- Shipbuilding
- Design, development, and manufacture or modification of complex aerospace or electronic equipment to a buyer’s specification and related services
- Construction consulting and construction management
- Architectural or engineering design services
- Software or a software system requiring significant production, modification, or customization of software
The term “complex,” as used in ASC 605-35-15-3(c), is not defined and is subject to interpretation. We generally believe that aerospace or electronic equipment, or other manufactured equipment that must meet the unique specifications of a particular application, are within the scope of ASC 605-35. For example, commercial aircraft components that are highly engineered to meet strict tolerances would generally be considered complex and within the scope of ASC 605-35. Similarly, complex industrial equipment (for example, turbines, generators, specially engineered industrial pumps) designed for a specific customer application and use would likely be within the scope of ASC 605-35. Conversely, manufactured products that are fabricated essentially to “stock” specifications, even if highly engineered and complex devices or “made to order,” would generally not be within the scope of ASC 605-35.
In addition to specifically excluding contracts subject to other specialized GAAP, ASC 605-35 also provides a list of example contracts not within its scope, including:
- Standard manufactured goods
- Supply contracts for homogeneous goods from continuing production over time
- Service contracts of health clubs, correspondence schools, and similar consumer-oriented reporting entities
- Magazine subscriptions
11.5.3.1 Recognizing a loss under ASC 605-35
A reporting entity recognizes a loss for construction-type and production-type contracts when the current estimate of total costs at completion of the contract exceeds the total consideration the reporting entity expects to receive. The entire expected loss should be recorded in the period it becomes evident. Management should estimate total consideration by applying the principles in the revenue standard for determining and allocating the transaction price. However, the estimate of total consideration should be adjusted to exclude any constraint on variable consideration in accordance with ASC 605-35-25-46A and adjusted to reflect the customer’s credit risk. Estimated contract costs should include costs that relate directly to the contract, as provided in ASC 340-40, including direct labor, direct materials, and allocations of certain overhead costs. Other factors to consider in estimating contract losses include variable consideration (for example, bonuses or penalties), nonreimburseable costs on cost-plus contracts, and change orders that are accounted for as contract modifications (refer to RR 2.9) in accordance with ASC 606.
The lowest level required for determining loss provisions for construction-type and production-type contracts is the contract level, after considering the guidance on combining contracts in the revenue standard (refer to RR 2.8). However, the guidance permits an accounting policy election to determine the provision for losses at the performance obligation level. Management should apply this election consistently to similar types of contracts.
Example RR 11-14 illustrates the loss provision guidance.
EXAMPLE RR 11-14
Loss contracts – construction contract
Loss contracts – construction contract
Manufacturer enters into a contract to manufacture three specialized construction vehicles over a five-year period. Management concludes the contract is in the scope of ASC 605-35 because of the complex and specialized nature of the machines. At contract inception, Manufacturer anticipates the contract will be profitable. However, in the third year of the contract, due to an unexpected increase in production costs, Manufacturer anticipates the contract will generate a loss overall.
Should Manufacturer record a liability in year three to recognize the anticipated loss on the contract?
Analysis
Yes. Manufacturer is required to record the anticipated loss in the period the loss becomes evident because the contract is in the scope of ASC 605-35.
Question RR 11-8
Manufacturer enters into a contract with a customer that has components in and some components out of the scope of ASC 605-35. Should Manufacturer apply the guidance on contract loss provisions to the contract as a whole?
Manufacturer enters into a contract with a customer that has components in and some components out of the scope of ASC 605-35. Should Manufacturer apply the guidance on contract loss provisions to the contract as a whole?
PwC response
If Manufacturer elects to determine the provision for losses at the performance obligation level, we believe that Manufacturer should only apply the loss provision guidance to performance obligations that are in the scope of ASC 605-35. If Manufacturer elects to determine losses at the contract level, we believe it is appropriate to apply the loss provision guidance only to the portion of the contract that is in the scope of ASC 605-35. However, given the guidance refers to “contract,” as defined by the revenue standard, we believe other approaches may be acceptable, including applying the guidance to the contract as a whole. Reporting entities should apply a consistent approach to similar contracts and provide appropriate disclosure, if material.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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